American Chemical Corporation

I prepared my answers by myself before discussing the case with anyone else. I only consulted other members of this class and this work is my own. Authors: Philip Larson In particular, I consulted Matt Thompson.

American Chemical Corporation Philip Larson

1) Do the circumstances surrounding the sale of the Collinsville plant play any role in your willingness to buy the assets? If so, how, if not, why not? On the one hand, the circumstances of the sale make me less willing to buy. In particular, both Universal and the federal government think that Americans acquisition creates antitrust issues. If this is the case, American could use its market power to change the nature of the market and make i!ons new plant unprofitable by setting lower prices for sodium chlorate in its other plants. On the other hand, the circumstances make me more willing to buy the assets because American has to divest the plant to comply with a court order. "herefore, they have less leverage during the sale because there are only a limited number of purchasers and American must sell. I would be more willing to purchase the plant given that demand for sodium chlorate is e!pected to continue increasing. On the other hand, power costs which account for the ma#ority of manufacturing costs were rising making it more e!pensive to produce. 2) Which firms are relevant for obtaining an asset beta for the Collinsville investment? sing the betas, determine the appropriate discount rate for the investment! "valuate the investment! $e are interested in obtaining the asset beta for the %ollinsville investment. $e can estimate asset betas by &' looking it up in (loomberg, )' finding *identical twins+ and comparing their betas, and ,' un-levering the beta from the company itself. .ere, using ) and , we are interested in both the asset beta of i!on as well as the asset betas of companies whose assets are similar to the pro#ect /e.g. companies that own plants that produce 0odium %hlorate'. .ere, assuming a low grade debt beta of .,, i!on has an unlevered beta of .1, based on the average debt2equity ratio from &314-&313.& .owever, it is important to note that i!on has reduced debt in recent years so the unlevered beta goes up to .5& when unlevered using an average debt2equity ratio from &3156&313 only.) 7ooking at *identical twins+, we look at the financial statements of selected sodium chlorate producers listed in 8!hibit 4. Using the estimated debt betas for different types of bonds from our class notes, the unlevered betas for these companies range from .43 to &.91 with an average of .39., .owever, since we are evaluating the addition of a sodium chlorate plant, the two firms /(runswick and 0outhern' who speciali:e in producing sodium chlorate are likely the best *twins+. "hey have betas of roughly .34. .owever, given i!ons beta of .5& I used an asset beta for the %ollinsville investment of . 3. Assuming a mar#et ris# premium of $!%& and a ris#free rate of $!'& /from footnote ) in the case, long-term treasury bonds of 3.4; minus &;', this means the equity cost of capital will be 5.4;<.3=5.>; ? &@.9@;. A range for the equity cost of capital using the broader set of *identical twins+ /including all companies in 8!hibit 4' would be /3.4; <.43=5.>;, 3.4; < &.91=5.>;' or /&>.4; to &5.4;'. Aiven that the investment pro#ect is &99; equity financed, the appropriate discount rate should be in this range. "o evaluate the investment using this range of discount rates, we must identify the after-ta! cash flows from the investment.> I first assumed that sales cannot e(ceed )$*** tons /due to the >9,999 ton capacity constraint and a margin for unsellable output' and a growth rate in price per ton of 5; through &353. Be!t, I assumed power cost growth rate of &);, graphite and salt e!pense growth rate of 4; annually, and that selling costs would remain roughly .1; of sales. "hird, I assumed that B$% would remain at 3; of sales based on AC staying at &9; of sales and
1 2 3

See Table 1 in Appendix. See Table 2 in Appendix. See Table 3 in Appendix. A!ter"tax cash !lo#s $ %&IAT ' depreciation in(estment.

American Chemical Corporation Philip Larson Inventory staying at >.4; of sales. Dinally, while the case stated that annual capital e!penditure would be within E>14k and E@99k, the actual %ap8! in &35, and &35> was E@91k and E@95k respectively. I therefore assumed an ongoing Cap"( of +,**# annually from &354-&353. I have further assumed, per the case, that there is no terminal value because the plant essentially has *no salvage value+ after &353. $ith these assumptions, the present value of the total cash flows value the plant at +-!./.4 Under this valuation, the E&)F offer seems high and that i!on should not make the investment without the laminate technology. 8ven if we rela! the assumptions and use the lower end $A%% in our range of &>.4; and assume that capital e!penditures will be the low end of the range at E>14k per annum after &35>, the deal at E&)F would still be dilutive because the %D value is still only +$!./.@ At the other e!treme, assuming a $A%% of &5.4; and capital e!penditures of E@99k per annum, the plant is only worth +-!'/. $hile the model above does not account for the return of working capital at the end of year in &353, the discounted value of this working capital is only worth about E@49k and therefore does not substantially alter the analysis. Aiven this analysis, the deal is dilutive and i!on should not make the investment. )) "valuate the marginal impact of the laminate technology 0i!e! net present value of the costs savings and e(penses assuming that without laminate, graphite costs go up '& per year after 1.$% and power costs rise 12& after 1.$%)! "he laminate technology requires an upfront capital e!penditure of E).)4F that can be straight-line depreciated over &9 years. "his laminate will eliminate graphite costs completely and reduce power costs by &4-)9;. Assuming the laminate could be installed by ecember ,&, &359 these costs would be incurred2saved starting at the beginning of &35&. "his would add a capital e!penditure of E).)4F to the end of &359 and will add E))4,999 of additional depreciation per annum to the cash flow analysis done above. $ith the same assumptions from G) above, and further assuming power costs reduce by &1.4;, the deal would be valued at +.!,/.1 "herefore, the marginal impact of the laminate technology is roughly +1!-/. "herefore, the addition of the laminate technology does not make the deal accretive at a E&)F offer. It is important to note, that even loosening the assumptions by using a $A%% of &>.4; and changing ongoing capital e!penditures to E>14k does not make the deal accretive. "he valuation with these assumptions is still only +11!)/, which is not enough to #ustify the E&)F offer.5 0imilar to G) above, while this model does not account for the return of working capital at the end of &353, including this value is not enough to make the deal accretive. "herefore, even with the laminate technology i!on should not do the deal for E&)F. %) 1hould Di(on purchase the Collinsville plant? 2ow much should he be willing to pay? i!on probably should not purchase the plant unless it believes that the synergies with its e!isting business will significantly add to the value of the deal. If the laminate technology does not work or is not installed on time, the deal is incredibly dilutive at a E&)F offer as shown in G) above. Her G, above, the deal is still dilutive at E&)F even if the
)

See Table 4 !or anal,sis. . See Table 5 !or expenditures. 2 See Table 6 !or 3 See Table !or

*C+ anal,sis #ithout laminate technolo-, as #ell as the assumptions !or the /&est Case0 *C+ anal,sis #ith modi!ied assumptions !or 1ACC and annual capital *8!pected+ %D Analysis Including 7aminate "echnology. /&est Case0 *C+ anal,sis that includes the laminate technolo-,.

American Chemical Corporation Philip Larson laminate works perfectly and is installed on time. "his assessment is valid even under *best case+ analyses that decrease the discount rate to &>.4; and decrease the required ongoing capital e!penditures to E>14k per annum. Cather, i!on should not pay more than E3.@F for the plant and should only pay this price if it is assured that the laminate technology will be installed ontime and will have the desired benefits. "o protect against the risk that the laminate is not installed on time or does not work as advertised, i!on may want to structure an offer such that it pays a smaller amount upfront /E1.4F, for e!ample' with an additional payment /e.g. E&.4F, for e!ample' due on Ianuary &, &35& once the laminate is installed and working properly. ') Which are the most critical sources of value? 0e!g! which assumptions have the biggest impact on your answer?) Dirst, one of the most critical sources of value is the laminate technology. "his technology adds about E&.1F in additional value to the deal. "herefore, the assumption that the laminate technology will be installed by Ianuary &st, &35& and that it will have the desired effect of eliminating graphite costs and cutting power costs is critical to the deal. 0econd, the $A%% is also a critical assumption that has a large impact on the answer. In the scenario without laminate, changing the $A%% from &>.4; to &5.4; changes the value of the plant by roughly E&.4F. 0imilarly, ad#usting $A%% in the scenario with laminate technology, the same change affects the valuation by appro!imately E).4F. "hird, the growth rate of the price per ton of sodium chlorate is an incredibly important assumption. If the assumption of 5; is loosened, the difference between using a @; growth rate and a &9; growth rate in both the laminate and no laminate scenarios affects the valuation by about E).1F. Dourth, the &); growth rate in power costs is also an incredibly important one that has a large impact on the valuation. Fodifying the growth rate from 5; to &@; changes the valuation by roughly E).,F in the no laminate e!ample and by about E).4F in the laminate e!ample. Difth, the assumption that the plant has no ongoing value after &353 is critical. If one assumes that the plant can keep producing sodium chlorate at &353 levels with a moderate terminal growth rate, the deal with laminate quickly becomes accretive.

American Chemical Corporation Philip Larson

3ppendi( 4able 15 Calculating the n6levered 7eta for Di(on 03ssuming 8irm9s Debt is :is#free)
Dixon Corporation Financial Data 1975 7314 12029 0.61 0.39 0.3 1.06 0.60 1976 6836 13268 0.52 0.48 0.3 1.06 0.67 1977 6402 14849 0.43 0.57 0.3 1.06 0.73 1978 6138 17382 0.35 0.65 0.3 1.06 0.79 1979 6113 20831 0.29 0.71 0.3 1.06 0.84 Avg ('75-'79) 6560.60 15671.80 0.44 0.56 0.30 1.06 0.73

Debt Total Liab D/(D+E) E/(D+E) D E 45 $ 4% 6 %78*'%9

4able 25 Calculating the n6levered 7eta for Di(on using only 1.-$ and 1.-. debt;e<uity data
Dixon Corporation Financial Data 1978 1979 Avg ('75-'79) Debt 6138 6113 6125.50 Total Liab 17382 20831 19106.50 D/(D+E) 0.35 0.29 0.32 E/(D+E) 0.65 0.71 0.68 D 0.3 0.3 0.30 E 1.06 1.06 1.06 45 $ 4% 6 %7 0.79 0.84 0.81 8*'%9

4able )5 Calculating the n6levered 7eta for =ther 1elected >arge 1odium Chlorate ?roducers
Pennwalt 1974 0.28 0.72 0.21 1.33 1.02 1975 0.34 0.66 0.21 1.33 0.95 1976 0.33 0.67 0.21 1.33 0.96 1977 0.34 0.66 0.21 1.33 0.95 1978 0.33 0.67 0.21 1.33 0.96 Avg ('75-'79) 0.68 0.21 1.33 0.97

D/(D+E) E/(D+E) D E 45 $ 4% 6 %78*'%9 ' 4* 6 *78*'%9 Kerr McGee

D/(D+E) E/(D+E) D E 45 $ 4% 6 %78*'%9 ' 4* 6 *78*'%9 International Minerals

1974 0.19 0.81 0.2 1.06 0.90

1975 0.20 0.80 0.2 1.06 0.89

1976 0.24 0.76 0.2 1.06 0.85

1977 0.21 0.79 0.2 1.06 0.88

1978 0.17 0.83 0.2 1.06 0.91

Avg ('75-'79) 0.80 0.20 1.06 0.89

1974

1975

1976

1977

1978

Avg ('75-'79)

American Chemical Corporation Philip Larson

D/(D+E) E/(D+E) D E 45 $ 4% 6 %78*'%9 ' 4* 6 *78*'%9 Georgia-Pacific 1974 0.45 0.55 0.2 1.5 0.92 1975 0.42 0.58 0.2 1.5 0.95 1976 0.22 0.78 0.2 1.5 1.21 1977 0.29 0.71 0.2 1.5 1.12 1978 0.29 0.71 0.2 1.5 1.12 Avg ('75-'79) 0.33 0.67 0.20 1.50 1.07 0.42 0.58 0.21 0.81 0.56 0.38 0.62 0.21 0.81 0.58 0.37 0.63 0.21 0.81 0.59 0.36 0.64 0.21 0.81 0.59 0.32 0.68 0.21 0.81 0.62 0.37 0.63 0.21 0.81 0.59

D/(D+E) E/(D+E) D E 45 $ 4% 6 %78*'%9 ' 4* 6 *78*'%9 Brunswick Chemical

1974 D/(D+E) E/(D+E) D E 45 $ 4% 6 %78*'%9 ' 4* 6 *7 8*'%9 Southern Chemicals 1974 D/(D+E) E/(D+E) D E 45 $ 4% 6 %78*'%9 ' 4* 6 *7 8*'%9

1975

1976

1977 0.19 0.81 0.2 1.1 0.93

1978 0.15 0.85 0.2 1.1 0.97

Avg ('75-'79) 0.17 0.83 0.20 1.10 0.95

1975

1976

1977 0.28 0.72 0.2 1.2 0.92

1978 0.21 0.79 0.2 1.2 0.99

Avg ('75-'79) 0.25 0.76 0.20 1.20 0.96

American Chemical Corporation Philip Larson 4able %5 @"(pectedA DC8 3nalysis of Investment without >aminate 4echnology

American Chemical Corporation Philip Larson

4able '5 @7est CaseA DC8 3nalysis of Investment without >aminate 4echnology

American Chemical Corporation Philip Larson 4able ,5 @"(pectedA DC8 3nalysis Including >aminate 4echnology

American Chemical Corporation Philip Larson

4able -5 @7est CaseA DC8 3nalysis with >aminate 4echnology

American Chemical Corporation Philip Larson